The problem with award-winning funds

Commentary: Investors need to look longer term

It’s awards season, and while most folks are focused on the Golden Globes and the Oscars, mutual-fund investors just saw the industry’s biggest honors go out this week, when researcher Morningstar revealed its Manager of the Year Awards.

For investors, it’s nice to see the manager of a fund you own recognized — that applies to one of my fund managers this year. And Morningstar’s own website suggests that earning the honor makes a manager part of the Morningstar Hall of Fame.

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But the awards themselves highlight some of the difficulty in deciding who should be running your money and whether you want to pursue a manager at the height of their fame.

All were stellar, top-of-the-peer-group performers last year and, in fact, over the past three years and five years — long enough that investors should be comfortable with the idea they would be buying a good fund if they got in now.

Here’s where the art and the feelings come in.

Just like how it’s easy to assume that an Academy Award-winning actor’s films will always be good, it’s easy to be complacent and figure that award-winning fund managers will always give a solid performance.

Yet an actor is only ever as good as his or her next film. Anyone who saw Rocky II, III, IV and V — not to mention virtually any other Sylvester Stallone movie — never quite got the same feeling they did out of the original Rocky, which earned Best Picture honors in 1976.

Yes, there are some fallen angels like Bill Miller, the former manager of Legg Mason Value Trust
LMVTX, +1.56%
, whose streak of 15 calendar years beating Standard & Poor’s 500-stock index was followed by a spate of stunning underperformance that ultimately overshadowed his greatness. But those are few and far between.

More common is a case like Bruce Berkowitz, manager of the Fairholme fund
FAIRX, +0.76%
, who was Morningstar’s equity manager of the year in 2009. In two of the three years since winning the award, Berkowitz has been at the very top of his peer group; in between those two years, however, he finished dead last in his peer group for 2011, with a loss of 35%.

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His three-year returns since winning the award, not surprisingly, are at the bottom of the peer group.

Neither Berkowitz nor Morningstar would apologize for that, nor should they. The fund manager has stuck to his guns throughout, and Morningstar’s analysts always say they like managers who follow their process through thick and thin; that helps to explain why Fairholme gets a positive “silver” rating from Morningstar’s analytical team. (Morningstar assign ratings on a five-tier scale with positive ratings of gold, silver and bronze, a neutral rating and a negative rating.)

For an investor, however, that’s not necessarily good enough. If you bought into Berkowitz’s fund based on seeing him capture the award — and without the requisite knowledge of “How does he do it?” — you almost certainly were disappointed when the fund imploded. Even investors who were familiar with Berkowitz’s style felt the 2011 downturn was more severe than anything they might have forecast based on his history.

That’s why awards — even those like Morningstar’s that are based on much more than simply topping the performance charts — are no better than a first step in picking investments, rather than a deal-clincher.

Countless studies show that funds typically earn much greater returns than the investors who own them, the disconnect being that those shareholders waited until there was good performance to buy in, and then sold during a period of poor results, whether those declining numbers were simply a result of major market forces or were a sign of a manager slipping.

It’s akin to looking at those movies and wondering whether it was the great acting, or whether the writing and directing made it virtually impossible for any actor in the role to fail. Sometimes, the market fools investors into believing that top returns during good times are a sign of managerial brilliance, rather than a result of being in the right vehicle at the right time.

Honoring the manager of the year is great, but investors need to be looking for the manager of the next half-decade or longer, and no plaque or trophy will show them that. Focus on the characteristics that make a manager appealing; if you can’t see yourself sticking with a mutual fund manager through years when performance isn’t going to win them any prizes, maybe you shouldn’t jump in with them when they are a big winner.

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